Keeping calm at the cliff's edge

Larry Stein is the founder and CEO of
Disciplined Investment Management,
an investment advisory firm that caters to high net worth clients in Chicago’s
North Shore suburbs. Since most of the firm’s clients are either retired or
planning to retire in the next five-15 years, Larry is committed to managing
risk, achieving their goals, and giving them peace of mind. The firm also works
closely with women in transition, particularly widows and divorcees, providing
high levels of personal care. The CFP Board Ambassador for Chicago, Larry is the
author of two investment books. His most recent work is "Peace
of Mind Investing," which is also written for retirees and those planning to
retire. You can follow him on Twitter:
@LSteinInvest and
Facebook. He
can be contacted through his website:
Disciplined-Investment.com.

This is not an easy time to be a retiree. You've spent your lifetime building up savings, and now your hard-earned portfolio may be at the mercy of politicians and their high-stakes "game of chicken."

Fortunately, there is no shortage of predictions. The upside narrative makes a lot of sense: The Fiscal Cliff will be solved, it will give corporate America the confidence to hire workers and expand, and the economy will be set on a new course of prosperity.

Then there's the downside argument: The politicians can't come to a resolution within a reasonable period of time, and this will cause investors to lose confidence and stock prices to tumble. Or a solution is passed, but Wall Street doesn't approve and stocks decline. Both the positive and negative predictions make sense. Also see: Obama ‘cliff’ bid trims Social Security

Unfortunately, neither prediction commands an overwhelming degree of probability. There are arguments to be made for both sides — bullish and bearish — and the magnitude of a move on either side could be substantial.

Of course, there's a third possible outcome: The markets may simply stabilize and be unfazed by the drama. It's impossible to know.

The cliff is more than politics

While the fiscal cliff itself may be the product of politics, the potential outcome could be very real from an economic standpoint. As noted above, a successful resolution could power the economy to higher levels, perhaps even setting it on a sustainable cycle of new growth. In that case, of course, the stock market could soar. But a negative outcome could lead to a loss of confidence in the US markets, and perhaps a recession; both of which could trigger a bear market.

Valuation metrics are also uncertain. While a traditional P/E ratio suggests the stock market is at attractive valuations, other less-conventional measures place stocks at fully valued or overvalued levels. To date, stocks have climbed higher in the face of fiscal cliff concerns, perhaps suggesting that investors expect a positive outcome. It's interesting to note that stock prices seem to rise handsomely after positive announcements on the fiscal cliff, while negative announcements have had much less of an impact to the downside.

What to do?

While my crystal ball is especially cloudy right now, I believe the course of action for retirees is fairly clear: Preserve capital. If stocks were already at low valuations, my answer might be different. But with stocks less than 10% from all-time highs, the downside potential is beyond my comfort zone for retirees.

A working person under 50 can shrug off times of great uncertainty. If the market declines sharply, a younger person has plenty of working years and market cycles in their future. They can continue to work, add to their savings, and eventually their equity losses will recover and turn into gains.

But as a retiree, with little or no prospects for work, and the need to generate income from your portfolio, a major decline in net worth could impact your retirement and cause sleepless nights. For retirees, the best course of action in times of extreme uncertainty is to preserve capital; don't risk a major loss.

Sure, the market could shoot higher, and there's a reasonable chance it will. But even if it does, you would still benefit to some extent from a reduced equity position. Instead of a 20% return, wouldn't 5%-10% be good enough? On the other hand, a major decline in stock prices could impact you for the rest of your life. Is the risk really worth it?

Keeping calm

The best way to maintain your peace of mind at the cliff's edge is to settle in with an asset allocation that will offer the protection you need to sleep well at night. There are no magic formulas. If your current equity allocation is conservative enough for you to withstand a sharp decline in stock prices, and your fixed income allocation has a solid mix of high quality bonds at reasonable maturities, then that's fine, there may be no need to change a thing. If you're comfortable with a wide range of market outcomes, you're probably in a good position and can stand pat.

But if you feel you might begin to lose sleep if the market takes a tumble, perhaps you should reduce the equity in your portfolio. You can always restore the equity allocation once the uncertainties are a bit less severe (the investment markets are always filled with some level of uncertainty) or when equity valuations are much more attractive.

If you feel a need to lighten up on your equities, be conservative with the funds raised. Place the cash in high quality short- or intermediate-term bond funds, or money markets. Liquidity is important, since you will probably want to redeploy the assets into equities at some point. This is no time to be cute — it's not the time to reach for yield or seek diversification in exotic market sectors.

Historically, during major declines in equities, most asset categories tend to fall together. While other asset classes stumble, high quality bonds with moderate maturities have generally held their value. Even in 2008, when stocks lost 37%, and alternatives such as gold, real estate and high-yield bonds suffered major losses, the overall bond market gained 5% (as measured by the Barclay's Capital US Aggregate Bond Index) and intermediate-term Treasury bonds did even better.

The fiscal cliff may come and go like many other political events, without much impact at all on stock prices. However, just in case a volatile situation develops, it's worth taking a critical look at your portfolio to make sure you can comfortably withstand a wide range of potential outcomes.

For retirees, especially during these times of great uncertainty, peace of mind is paramount.

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